How stockbrokers dealt themselves out of the game

In early January, UBS bank analysts Jonathan Mott and Chris Williams caused a stir when they published a research report claiming the share price of
Macquarie Group
would rally sharply if it shut down its broking arm, Macquarie Securities. Inside Macquarie, the report was dismissed as a frivolous cheap shot: an attempt to save face by a pair of analysts who’d failed to predict the rally in Macquarie’s share price from $24 to $35 over the past 12 months.

Rivalries aside, the report was a damning indictment of the business case for institutional stockbroking from two highly regarded analysts reflecting on their own careers.

The report was about Macquarie, but most of the problems it raised – weak volumes, poor deal flow, increased competition, pressure on commissions, and the rise of algorithmic and high-frequency trading – applied to just about every stockbroking business in the country. Once the money-making backbone of an investment bank, stockbroking is now a barely profitable business for the top players in Australia.

Global investment banks don’t split out the earnings of their Australian businesses, let alone the performance of individual units, but industry sources suggest UBS and Macquarie would be the only two banks likely to have made a small profit stockbroking in Australia in 2012.

2007: Trading room, UBS Warburg, Sydney.
AFR

Some of the challenges are part of the economic cycle. Nervous investors are trading less and fewer companies are listing on the stock exchange or raising capital, giving brokers few opportunities to issue new stock.

The sharemarket has had a strong start to 2013 and more Australian companies might raise capital for mergers and acquisitions this year. But most have strong balance sheets after raising more than $100 billion in 2009 following the financial crisis, depressing demand for broking services.

More troubling are the structural changes. Fund manager clients are doing it tough, under pressure from superannuation funds that are consolidating, bringing investment management in-house and awarding fewer mandates. The MySuper reforms have sharpened super funds’ focus on fees, and fund managers in turn are pushing for cheaper brokerage.

Competition has also stepped up in recent years with Asian brokers such as Nomura, CLSA and CIMB entering the Australian market. But the biggest structural problem is the growing prevalence of electronic algorithms capable of executing orders faster than humans and at a fraction of the cost.

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First mover advantage

Thirty years after robots replaced assembly-line jobs in the auto industry, computer programs are executing trades more efficiently than stockbrokers and making many of them redundant.

Two of the Australian market’s biggest players, Citigroup and UBS, led the move into advanced electronic trading five years ago, offering buy-side firms direct market access (DMA), which enabled their clients to access the order book of the stock exchange. Previously, such access was limited to members of the exchange: broker dealers and market makers at the banks. But Citi and UBS allowed clients to use their computer systems to access the exchange, and in the process, disintermediated themselves as gatekeepers to the market.

The move seemed crazy to competitors, but Citi, forced to reinvent itself after the financial crisis, saw the direction trading was heading in United States. The bank reasoned it was better to move first in Australia and be a market leader in the new low-cost market. It would only hasten the inevitable.

Once the floodgates were open, other banks were forced to either follow suit or watch their market share erode. Citi claimed the top spot for broker market share for the first time in 2012, edging out long-time leader UBS. It has been a rapid rise for Citi, which was ranked fifth at the end of 2009. (The bank says its ascent is also due to winning more equity capital markets work and its improved relationships with fund managers.)

“It doesn’t pay the bills," he says. “A lot of the big brokers are dealing [with their clients] through direct market access for a handful of basis points, and people wonder why they are sacking people, left, right and centre. We’re sticking to the old-school business of crossing large tickets."

There is still demand for the handmade artisan product, especially when dealing in less frequently traded stocks. Clients will pay a decent commission to a broker who can work their contacts to execute a large or complicated order at a good price without tipping their hand to the wider market. The skilled desk operator filling an order in the sharemarket, or “down the pipe", can also have an edge over a machine.

The big banks say traditional broking is still a big part of their business, but providing DMA adds marginal revenue and is a service clients would get elsewhere if they didn’t provide it. None will admit their own business model is under threat or criticise others on record, but every chief executive Capital spoke to for this article says the proliferation of DMA has made their competitors’ business models unstable.

It’s unclear to what extent DMA will take over, but one professional investor says about 80 per cent of their trades are now done electronically for about 4 basis points (bps) per trade. Three years ago, brokers charged fund manager clients about 30bps a trade. The most they can charge now is 10bps to 15bps for tricky, manually executed transactions.

Not surprisingly, most of the job cuts at investment banks in Australia over the past 12 months have been in sales trading and execution departments, which at some banks have shrunk by 40 per cent. Those employees won’t be coming back when the market rebounds. Research analysts – who provide the company and market analysis that gives clients trading ideas – have also been sacked in large numbers and more job cuts are expected.

“If I was an assistant sector analyst at a major investment bank I would be very nervous right now," the head of dealing at one bank says.

Reinvention with a purpose

Of course, just because a unit is unprofitable does not mean it will be shut down. Many of these electronic broking businesses are being run with grander schemes in mind. Commonwealth Bank of Australia opened its Institutional Equities business just three years ago, well after the advent of DMA, and oddly, just as global players were moving their businesses away from investment banking and back towards the CBA-style basic banking model that helped Australia avoid the worst of the financial crisis.

CBA’s head of institutional equities, Jay MacGregor, says offering an institutional brokerage service and funding the equity research team to go with it is about more than trying to earn commissions on trading activity.

“It’s like saying ‘bread is loss-making’ to a major retailer, so why do they sell bread? In isolation, research could be viewed as a problematic cost, but if you look at the benefits research provides the overall CBA network, it’s something that you really need and delivers heaps of value."

The average bank spends about $15 million annually on a team of 20 to 30 analysts and sales traders. Before the financial crisis, banks had more flexibility to adjust bonuses when times were tough. But when politicians in the United States and Europe threatened to place limits on bonuses a couple of years ago, banks hit back by lifting base salaries by about 30 per cent.

In 2012, as trading volumes remained weak and ECM work dried up, banks had to cut costs and were forced to lay off analysts and sales traders. The stockbroking businesses of most investment banks have shed 25 to 30 per cent of staff over the past 12 months. The latest entrant to the Australian market, Malaysian behemoth CIMB, cut staff when it acquired Royal Bank of Scotland’s assets but was able to keep more analysts by negotiating a 10 to 15 per cent pay cut by issuing employees new contracts under a new owner.

Banks that have been forced to cull research teams heavily are starting to question whether a 120-page daily market report is the best use of limited resources.

US bank Morgan Stanley is one of the few major banks that doesn’t publish a daily research report. It entered the Australian market relatively late, in 1998. The bank employs 72 analysts and traders, one of the largest teams in the Australian market. Instead of distributing research they try to provide bespoke advice on a client-by-client basis.

“We viewed adding another daily product for the Australian clients as the wrong strategy," he says. “Our strategy is about competing in the things we’re good at. Our focus is on providing targeted company research, industry perspectives and insights into macro and global issues."

Its competitors argue a bank cannot run a successful broking business without a daily research report, but Morgan Stanley’s steady rise up market-share league tables over the past 15 years suggests otherwise.

Survival of the fittest

The evolution of Australian funds management businesses has also played a part in creating this volatile environment. Ten years ago, the average fund manager was a two-person operation that relied heavily on an investment bank’s forecasts and recommendations. These days, fund managers employ their own team of analysts and see their investment bank as more of a trading consultant.

“They want to know: should I go through a dark pool, buy in a block or drip-feed my order into the market?" Macgregor says.

For brokers, it’s important to be among the top five, ideally the top three, in the “panel ranking" of the biggest fund managers in the market. Panel ranking is the points system that fund managers use to determine which brokers execute their trades. About half the rating still depends on the broker’s ability to bring fund managers original ideas or trading opportunities. Liquidity and efficient execution (the ability to conduct a large trade cheaply without alerting the broader market) rank second.

Being in the top five is crucial because executing more trades for a larger number of clients creates greater liquidity. Flow begets flow in a virtuous circle. The trouble is there are 12 investment banks in Australia fighting for a place in the top five.

The Australian market has been described as over-broked for more than 20 years. The top tier banks have long pressured fund managers to give them more business and stop trading with so many of their competitors, but now the calls are becoming more urgent.

Goldman Sachs chief executive in Australia,
Simon Rothery
, says Goldman is seeing a trend towards a concentration of fewer brokers on client panels. “Clients are reducing the number of brokers on their panels given market conditions and pressures. Our discussions with them are around how we can deal with their execution and liquidity needs as they engage fewer brokers."

For those outside the top five, keeping a loss-making stockbroking business open in Australia may become untenable if they continue to lose market share.

Citi’s chief executive
Stephen Roberts
says his bank is in a strong position now because it was forced to make drastic changes in response to the financial crisis – Citi took its medicine early, he says, and other banks may still have some work to do.

“I do see there being continued rationalisation of platforms in Australia," he says. “Not just cash equities and trading but distribution too. To maintain returns, you have to cut expenses. Low return businesses are being looked at. The whole gamut is on the table. You will see changes to investment banking business models."

Citi’s rivals are quick to point out that market share does not necessarily imply a healthy, profitable broking business or a high standing in the panel rankings. The correlation between market share and revenue is now the lowest it’s ever been. The volume traded on the ASX was down just 4 per cent in 2011, but brokerage revenues were down 25 per cent. Not only is DMA affecting revenues, a number of banks are executing trades for free.

“There’s a trade-off between chasing market share and having a sustainable business that makes money" is a refrain repeated regularly by the heads of every bank outside the top three by market share.

Citi, for example, executes orders for Australian shares on behalf of Barclays clients globally at a very slim margin. UBS has a similar arrangement with BNP Paribas.

As global investment banks don’t publish the revenue figures for their Australian broking businesses, it’s unclear which bank is in the strongest financial position. The top five accuse the bottom rung of sour grapes and claim HFT and other activities are marginal and removing them would not change the market share rankings.

Fund managers say brokerage services would probably improve if some banks left the Australian market: five strong brokers would meet their needs better than a dozen under pressure to slash costs. This argument has been around for a long time, yet for years fund managers have continued to keep the second-tier brokers afloat.

“Part of the problem is the difference between one broker and another is not that stark," head of equities at Colonial First State Marcus Fanning says. “If the best research analyst for a particular company is at a smaller house we will still use them, and we don’t know who will have the next ECM deal we want to participate in. We want to get the best execution on the day. It’s also a tall poppy syndrome. No one wants one broker to get to 20 per cent market share."

As the fight over smaller commissions intensifies there will probably be more research reports suggesting a competitor should shut up shop.